Tuesday, 22 March 2016

Oil prices had
fallen from the $100-plus level sustained over 2011-13. The reasons for the decline
are also well-known: large new supply from US shale producers; OPEC’s
refusal to lower production; and weak global demand in 2014. These have made
the oil market over-supplied and led to a large build-up of inventories. But oil
markets, like any other market, have a tendency to rebalance themselves. Incoming
data confirm that the adjustment is indeed underway and could be behind the
recent mini-recovery in oil prices to around $40 per barrel.

When markets are
over-supplied, they tend to adjust in two ways. First, low prices push some
producers out of the market as they become unable to cover their costs. This
leads to a decline in supply, which should help the rebalancing. We are seeing
evidence of this among the high-cost producers in the oil market, namely shale producers
in the US. Production in the US has been in decline since it peaked in April
2015. And The
Economist reports that further declines
by more than 1 million barrels per day are expected in 2016-17.

The second adjustment
mechanism is through higher demand. Low oil prices encourage people to increase
their energy consumption by, for example, driving more and buying bigger cars.
They also make the switch to oil from other energy sources more attractive. Again,
the data support that demand is picking up. Last year saw the largest increase in
global oil demand since 2010, which is impressive given that the world
witnessed its slowest economic expansion over the same period. The boost to
demand was purely due to lower prices.

So there are signs
in the market that oil prices might have bottomed out. But two caveats apply. First,
the adjustment is likely to progress only slowly given the large build-up of
stocks that need to be cleared. Second, while some US shale oil producers are
being pushed out, they have changed the landscape of the oil market. Unlike
conventional producers, the response of shale companies to price swings is rather
quick. If oil prices recover to around $50-60, shale could become profitable
again, and production could soon increase as a result. This means that a world
with $100 oil price might well be a thing of the past, and that oil producers should
expect prices in the range of $50-60, at the very best.

Monday, 14 March 2016

By
defending an overvalued currency, the Central Bank of Egypt is merely delaying
the inevitable.

Egypt’s currency
crisis is intensifying. The price of the US dollar
reached 9.8 Egyptian pounds last week, 27% higher than the official rate. Despite
this, the central bank is still
resistant to any devaluation of the currency. Its resistance could prove ultimately successful only
if it is supported by economic fundamentals. But these point to an official exchange
rate which is well above its fair value.

The starting point for estimating the fair value of any currency is the
theory that prices of identical goods must be the same everywhere. Suppose that
the price of a can of Pepsi is $1 in the US and 2 pounds in Egypt. Then the
theory stipulates that the exchange rate must be 2 pounds for each dollar to ensure
that the price of Pepsi is the same in the two countries. If the exchange rate was
instead 1 pound for each dollar, investors would find it profitable to buy the
whole supply of Pepsi in the US (where it is cheaper) and sell it in Egypt
(where it is more expensive), which is obviously not a sustainable situation. This
theory is called Purchasing Power Parity (PPP).

But PPP needs to be modified before it can be used for obtaining a fair
value of a currency. Lower labour, rent and transportation costs typically result
in cheaper Pepsi in Egypt compared to the US, after taking the exchange rate
into account. Consequently, the Egyptian pound has traded below the
PPP-prescribed value. But deviations from PPP have been stable over time. Since
1988, the pound has tended to fluctuate around 21% of its PPP value. We can use this historical average (21% of PPP)
as a measure for the fair value of the pound.

What is the current fair value of the pound according to this method? Using
the International Monetary Fund’s estimates for PPP, the method suggests that
the fair value of the exchange rate is 11.9 pounds for each US dollar. This is 35%
above the official exchange rate of 7.73 pounds for the dollar. The prevailing
overvaluation is the largest since 1988 (see chart). No wonder there is intense
market pressure to devalue the currency.

How can this situation be resolved? A gradual devaluation of the currency
(say 10% each year) could allow a convergence to its fair value within a few years
without causing an abrupt disruption. But irrespective of its speed, an adjustment
is likely to start at some point in the near future. Resistance to devaluation
runs against economic fundamentals. By defending an overvalued currency, the
Central Bank of Egypt is merely delaying the inevitable.

Monday, 7 March 2016

By
reducing the funding available to oil-dependent governments, the recent rating
downgrades could lead to slower growth than previously expected.

A number of
oil-producing countries in the region were subjected to rating downgrades, a
re-assessment of their ability to pay back loans or make timely interest payments.
Saudi
Arabia’s credit rating was cut by Standard and Poor’s (S&P), one of the
three major rating agencies, on 17 February. Despite the downgrade, Saudi Arabia
still maintains medium/high credit worthiness. The same cannot be said about
Bahrain, which was assigned a junk status by both S&P
and Moody’s,
another major rating agency. This means that Bahrain has a high risk of failing
to service its debt. The
credit worthiness of Oman, another of the countries downgraded, is somewhere
in between its two Gulf neighbours.

Low oil prices are
the main reason behind the downgrades. They are leading to budget deficits
among the region’s oil producers, increasing the risk attached to each of them.

But not all
oil-producers were subjected to rating downgrades. Kuwait,
Qatar
and the
United Arab Emirates maintained their high credit worthiness by S&P. They
are assessed to have accumulated significant savings during the last oil boom, especially
in relation to the size of their economies. However, they were still put on negative
watch by Moody’s with a possible downgrade further down the line. Outside the
Gulf, Iraq’s credit rating was also maintained by Fitch, the third major rating
agency, although two caveats are in order. First, Iraq was also put on
negative watch with a possible downgrade in the future. Second, it had already
been assigned a junk status associated with a high risk of default.

Almost all of the
region's oil-exporters intend to borrow from investors to finance their
deficits, and the downgrades make this task more difficult. Saudi Arabia has plans
to borrow $30bn; Oman and Qatar up to $10bn each; and Iraq $2bn. The downgrades
would reduce investors’ appetite to lend to these countries. Even if they were
willing to lend, investors would charge higher interest rates to compensate for the additional risk.

The recent
experience of Bahrain highlights this issue. The downgrade of Bahrain by
S&P happened while the country was finalising a deal to borrow $750m from
international investors. The downgrade led to a change in the terms of the deal.
The amount Bahrain borrowed was lowered to $600m and the interest rates increased
by 0.25%. The change in rates was small suggesting that markets were partially
expecting the downgrade. But further deterioration in the ratings could worsen
the terms of borrowing further.

In summary, the
rating downgrades are propagating the oil price shock experienced by oil-producers.
Low prices are leading to budget deficits and the downgrades make these deficits
harder to finance. If rating downgrades result in reduced resources for the governments
to spend, then the impact on growth could be even worse than previously anticipated.

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About Me (Ziad Daoud)

I am an economist currently based in the Middle East. I have previously worked for an asset management firm and, before that, I did a PhD at the London School of Economics. The views in this blog are solely my own.